Stock Pitch - Record (LON:REC)

It’s been a tough ride on the stock market for Record. The currency management specialist floated in 2007 only to run straight into the Great Financial Crash, and the next decade was spent recovering from the fallout.

Management has worked hard to reposition the business but progress has been slow due to industry headwinds driven by a shift towards lower margin Passive Hedging. Record has created higher margin products to combat this, but new client mandates have proven tricky to come by.

Despite this headwind, Record has made a name as a sensible small cap stock well managed for its shareholders. Its profitable business model has been used to pay out ordinary and special dividends and buy back shares. The majority of its employees are equity holders and staff turnover is low.

There are strong foundations here but one vital ingredient has been missing: growth. That might now be changing, with a management reshuffle looking like the key catalyst. Since that change in early 2020, there has been investment in technology with an emphasis on scalability of operations and a more client-centric, demand-led emphasis on new product and service innovation.

Record was pitched to the Stockopedia Investment Club on 10th August 2021 at a share price of 88.4p.

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Bull points: stable client base; high margins and cash generation; renewed emphasis on growth; new client wins and products; decades of experience; modernised, scalable infrastructure; share buybacks and special dividends; strong balance sheet; 99 Quality Rank.

Bear points: trend to lower margin passive hedging has weighed on profits; hard to win new clients; sensitive to equity markets; currency management is optional for institutions; lack of historic growth.

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Profile

About the Stock:

Record (LON:REC) is an established currency services provider to institutional investors. It’s in the Financial sector in the Investment Banking & Investment Services industry group, with a premium listing on the Main Market of the London Stock Exchange.

The current share price is 88.94p, down from recent multi-year highs of 102p after a period of strong performance. The market cap is £175m and liquidity is reasonable, with a 23bps spread and an EMS of 7,500 suggesting around £7,000 can be purchased easily.

The shares come with an Adventurous RiskRating, although recent volatility has been firmly to the upside. The StockRank is 88, made up of:

• A Quality Rank of 99,
• A Value Rank of 30, and
• A Momentum Rank of 93.

The above factor profile makes Record a High Flyer, and one of the top Quality-Momentum stocks in the UK market with a QM Rank of 99.

About the Opportunity:

A refreshed management team and strategy hopes to move Record from stabilisation to growth.

As such, it can be classified as a ‘growth at a reasonable price’ (GARP) stock, with its forecast PEG of 0.6x, while its high QM Rank puts it firmly in High Flyer territory. The shares trade at a premium to its asset manager peer group on a forecast PE ratio of 17.1x, but, after years of minimal progress, earnings are forecast to grow by some 84% in FY22.

No company can grow by 84% forever, but Record hopes to generate longer term progress by innovating new products, winning new clients, growing AUME, and expanding services offered to existing clients.

New customers have proven tricky to come by but once they are at Record, those clients tend to stay and revenue from long term institutional mandates can be quite sticky. What’s more, existing clients typically increase their AUME (assets under management equivalent) at Record as the relationship develops.

There’s a good business here, one that has navigated industry headwinds, innovated, paid out dividends to shareholders, and bought back shares. It just needs to add meaningful growth into that mix - but are those industry headwinds just too much to combat?

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Business & Model

What is the company history & what does it do?

Record has been based in Windsor since its establishment in 1983, but it also has sales offices in New York and Switzerland. It is majority‑owned by its directors and employees.

The group provides currency management solutions for institutions and the majority of its clients have been with the company for more than six years.

Record has a long history as a currency manager and by the point of its ill-timed float back in 2007, it was a much larger business than it is today in terms of revenue and profit. That’s because it has been dealing with a shift from higher-margin absolute return currency services towards lower-margin passive hedging solutions ever since the financial crash.

Managing this dynamic has been the primary reason behind a previously uninspiring share price performance.

While the group has been battling this headwind, however, management has not been idle. We can see in the chart above that AUME growth has returned from a lower base as a result of an increasingly diversified product mix. This is key to the investment case.

And through these tough conditions, Record has remained strongly profitable and cash generative. It has used this cash to pay out substantial dividends and buy back shares, as well as using it to invest in headcount, IT systems, and product innovation.

What is the business model? How does it make money?

Record has 85 employees in Windsor, New York, and Zurich, $80.1bn AUME, and 89 clients including pension funds, foundations, and institutions.

Source: Company presentation, 2021

Its products enable institutions to either reduce risk or seek returns.

The bulk of Record’s AUME is in its enhanced Passive Hedging service, which aims to reduce the cost of hedging. It requires some discretionary oversight but is largely systematic and low margin.

The higher margin Dynamic Hedging product has seen encouraging net inflows recently following the start of a new mandate announced on 21 September 2020. This is where Record seeks to eliminate the impact of negative currency movements but not to do so when they are expected to result in an economic gain.

The bespoke Multi-Product mandates have combined risk-reducing and return-seeking objectives.

Record’s Currency for Return sees the group enter into currency contracts for clients with the objective of generating positive returns. The principal product recently has been the Currency Multi-Strategy, which combines market risk premia and behavioural strategies.

The Currency for Return product group allows clients to select their level of exposure by selecting the required level of scaling and/or the volatility target.

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Market & Competition

What is the state & size of the company's market?

The currency management and derivatives markets are big. Turnover in global foreign exchange (FX) markets reached some $6.6tn per day in April 2019, according to a BIS review. That will include a lot of speculative trading activity but even so, it suggests the market for a c£175m market cap company like Record is sufficiently deep.

That said, while these are large markets, Record has struggled to grow in the past. The investment case assumes that this is now changing.

Who are the company's key competitors?

Banks can set up currency management units but many of these competitors have not lasted as currency is a difficult game. Large asset managers might also offer it as a sideline and a way to cross sell services.

Banks can hide their fees in the spread, while large asset managers are more focused on their complimentary services.

Competition is a concern though. Mandates and revenues are quite sticky, but margins are temptingly high. The fact that management fees in bps have been coming down does suggest pressure here.

A quick google search instantly brings up alternative solutions, including, for example, Russell Investments.

What is the company's strategy?

The current strategy revolves around diluting Passive Hedging as a proportion of total AUME and emphasising higher margin, newer products. Record wants Passive fee income to be below 40% this year and new initiatives are playing a key role in that.

The board is attempting to shift the focus away from consolidation and towards sustainable profitable growth. This change in emphasis coincides with the appointment of Leslie Hill as CEO back in 2020.

Since then, Hill’s leadership has been focused on delivering modernisation, diversification, and growth. Or, as Hill puts is more colourfully:

I see the challenges we face as similar to those one would face when modernising and improving a house whilst still living in it, and also constantly receiving those much valued paying guests who are our clients.

Modernisation is primarily related to upgrading Record’s IT infrastructure. This will lead to a more scalable infrastructure.

The group is diversifying its investment offerings. Several initiatives are now underway, one of which has already resulted in the win of a large UBS mandate.

It’s likely that some new lines of business will not include currency management as their primary focus, and it is also likely that some of them will be margin-enhancing. In fact, this already appears to be the case, with management commenting in its most recent annual report:

The Board is pleased with the progress made in the year from the change in strategy, as evidenced by the increases in AUME and client numbers, the change in revenue mix towards higher-margin products, and the development of new products including the Record EM Sustainable Finance Fund.

Alongside this focus on modernisation and diversification is a renewed emphasis on winning new clients.

How does it derive its competitive advantage (if any), is it durable and is there evidence of one in the financials?

In a world now much more dominated by passive hedging demand, competitive advantages are harder to find.

That said, Record’s habitually strong balance sheet put it in a position to rebuild after the crisis when others could not. Since then, it has worked hard to diversify across the whole spread of currency activities. Its subsequent market position and client relationships are a strength.

Even with passive hedging pressures, Record remains a high-margin business with sticky revenues and a stable institutional client base. More than 60% of clients by AUME have been with Record for over six years.

The chart below is by client number, not AUME. Note how just over a third of clients have been there for six years or more but contribute more than 60% of notional assets under management.

Source: Company presentation, 2021

That’s because as clients stay with Record, they tend to increase their AUME. So new client wins can drive multi-year organic growth as they typically start off small and grow over time.

Recently, there have been positive signs here.

According to Hill:

The longevity of our client relationships is a source of real pride to us all and will continue; I often feel we are not so good at getting clients (but getting better as we offer more and better products) but we are really good at keeping them once we have them. Now if we can combine that with exciting new projects then I am confident we can move forward over the next decade without losing momentum.

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Financials & Ownership

What is the record of growth & profitability?

Although Record does have some obvious Quality characteristics, growth has been pedestrian.

This slow revenue growth has been supported by manual processes and headcount - so the cost base has increased proportionately, or even at a faster rate.

Consequently, net profit progress has been frustrating.

Part of the group’s strategy involves modernising its infrastructure and moving to third party systems for greater scalability. This will allow them to develop new products like the recent UBS fund launch and should also allow profits to grow.

What is the state of the balance sheet? (debt/cash etc)

Record’s balance sheet has traditionally been a source of strength due to its net cash position, strong cash generation, and low capex spend.

Current liabilities of £5.99m are well covered by cash and short term instruments of £19.8m. The group has negligible levels of debt.

Is there evidence of historic share dilution or buy backs?

Yes, there is evidence of share buybacks.

This trend is obscured by FY21 results, which reflect one-off restructuring costs and growth investment at the expense of shorter term profits. Margins are forecast to revert to the group’s previously higher levels and forecast FY22 EPS is 5.03p - 84% ahead of its FY21 equivalent and well above the preceding trend rate of growth.

The group also has a strong track record of returning cash back to shareholders via ordinary and special dividends.

What is the ownership structure of the company and do management have stakes?

Yes - shares are well held by staff and the Major Shareholders include Record’s group founder & chairman and the new CEO.

Recent director buying and selling activity has been mixed, however.

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Valuation

How does the relative valuation compare versus industry and sector?

The group trades on a premium valuation compared to other asset managers, but it also has a smaller market cap and higher forecast growth.

This makes for an attractive forecast PEG of 0.6x but, after so many years of broadly stable profits, it remains to be seen whether Record can maintain strong growth rates.

What is the intrinsic valuation of the business?

Although not a form of intrinsic valuation, reverse DCFs can be instructive. Rather than focus on cash flow growth assumptions, these models instead work out the market-implied growth expectations.

It still requires some subjective assumptions.

• With a share price of 89p, ​​199,054,325 shares in issue, and £19.162m in net cash, that gives Record a market cap of around £175m and an enterprise value of around £155m.
• If we assume that, five years out, Record reaches maturity with a terminal growth rate of 3% (roughly equivalent to its historic revenue growth rate), and
• Assume a 10% discount rate (an average figure for publicly traded companies),
• Then today’s share price assumes a free cash flow CAGR over the next five years of roughly 19% if we account for the net cash position as distributable to shareholders.

That’s significantly above the free cash flow per share CAGR of 5.42% on the StockReport, but then again Record is making good progress across a number of fronts with its growth strategy:

• There are early signs of new client wins, which will be a key driver of longer term organic growth,
• The company is creating new, higher margin products that are informed by client demand, and
• Tech investment is making for a more scalable business, so revenue growth should increasingly translate into net profits and cash flow.

What’s more, brokers are forecasting an 84.2% increase in earnings per share for FY22.

Record generally has very high levels of cash conversion. If we assume 100% for FY22 and treat it as a one off, keeping the rest of the assumptions the same suggests Record has to match FY22’s earnings per share target and then grow by 5.5% thereafter to justify today’s enterprise value.

So once the FY22 forecasts are factored in, it seems a much more modest set of expectations from the market.

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Trends & Catalysts

Are there any significant macro trends that the business is benefiting from?

• Globalisation is a persistent theme and institutional investors are increasingly overriding ‘home bias’ (the tendency to invest disproportionately in the domestic market).
• Nevertheless, currency management can still be seen as optional and some high profile investors don’t engage in it at all, believing that hard to predict currency moves will net off in the long term with sufficient diversification.
• It would be remiss not to once again bring up the well-flagged shift towards lower-margin passive hedging services at this point, as it is of fundamental importance.

Are there any catalysts that could drive a rerating in the medium term?

• Revamped management and renewed focus on growth and new client wins.
• Investment into people and technology. Updated infrastructure can make Record more scalable, more efficient at delivering passive hedging and spot FX execution (allowing staff to focus on more profitable initiatives), and make it easier to create new products and services.
• Diversification. Targeted areas are tailored to client demand and include ESG, impact investing, and the incorporation of frontier markets into products.

The first new product is the Emerging Market Sustainable Finance Fund in combination with UBS Global Wealth Management as a strategic partner. Fund size at launch is approximately $750m. The relevant RNS dated 29th June 2021 can be found here.

Focusing on the EMSF for a second, UBS sees this as a generational change product in order to retain younger clients who are much more sensitive to Impact and ESG investing. Importantly, the management fee will be much higher than for passive products and at a similar level to emerging market bond funds.

The initial fund size is larger than brokers initially forecast at $0.75bn, with scope for further growth. It promptly led to revenue and earnings per share upgrades. Robeco, Vanguard and Pimco’s similar funds have ongoing charges of 60–79bp. Deducting for charges and a competitive discount to peers suggests a level of around 40bp.

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Risks, Threats & Hurdles

What are the biggest risks, threats or hurdles that the business may face?

Major risks include:

• The continued shift towards passive currency hedging,
• The potential loss of major clients,
• Difficulty in winning new clients,
• Competition winning business, and
• Macro considerations - for example, a major market downturn similar to 07/08.

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Recent Trading & News

Summarise the most recent trading statements and comment on them

July 23rd 2021, Q1 Update

The new financial year has started well opening with a high level of AUME enhanced this quarter by further net inflows and the new fund launch. We will continue to focus on improving both our diversification and profitability, which will be achieved by delivering new and innovative products accompanied by the enhanced efficiency and scalability of our operational systems delivered through our ongoing investment in technology.

FY 21 Annual Report

Notwithstanding the short-term decrease in our profits for FY-21, we go into FY-22 with our highest ever AUME, the anticipated launch of our new EM Sustainable Finance Fund in collaboration with the largest Wealth Manager in Switzerland, and with the benefits of our modernisation starting to bear fruit.

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Sentiment

What do the brokers currently think?

Brokers rate Record a buy and have been nudging up earnings per share estimates. The sticky nature of the group’s business means that these increases feed through to following years.

What is private investor sentiment at the moment?

Private investor sentiment is positive, although there appears to be a degree of churn as some take profits.

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Conclusion

Due to our maximum position size of 16 in the Club, one stock also had to be put forward as a Sell in order to make way for a new position. After a year of range bound share price performance, a potentially risky large acquisition, and for the fact that it also is in the Financials sector, Ig Group (LON:IGG) was selected as the stock at risk.

Record is making good progress with new products, IT upgrades, and new client wins. After years of lackluster performance, there are promising early signs of growth. But it is also hard to escape the shadow of Passive Hedging and its impact on the group’s business, especially when set against IG Group’s superior long term growth rates.

Consequently it met with resistance and the Club voted to reject the pitch.

Was the Club right to turn down a company on a PEG of 0.6, forecast to grow earnings by 84% in the year ahead, or will this spark of growth ultimately fade away against the sector-wide shift towards lower margins?